IN THE COURSE OF FINANCIAL ACCOUNTING YOU HAVE THE TOPIC CALLED 'FOREIGN CURRENCY TRANSACTIONS'. In detail and clearly also step by step explain in responding to the listed below.

Question

1. Explain foreign currency transaction principles
2. Distinguish between functional currency and presentational currency;
3. Explain how foreign currency transactions carried out directly by the reporting entity in the financial statements;
3. Apply foreign currency transactions to overseas transactions and investments in overseas subsidiaries.

Answer 1

Certainly! Let's break down the topic of foreign currency transactions step by step:

1. Explain Foreign Currency Transaction Principles

Foreign currency transactions involve transactions that are denominated in a currency other than the functional currency of the reporting entity. The principles governing these transactions are rooted in the need to record, measure, and report the impact of foreign currency fluctuations on financial statements. Here are key principles to understand:

• Functional Currency: This is the currency of the primary economic environment in which the entity operates. It is the currency that most faithfully represents the economic effects of the underlying transactions, events, and conditions.

• Exchange Rate: When a transaction is entered into or recorded, an exchange rate is applied to convert the foreign currency into the functional currency. There are typically two rates to consider:

  • Spot Rate: The current exchange rate at the date of the transaction.
  • Closing Rate: The exchange rate at the end of the reporting period.

• Initial Measurement: At the time of the transaction, it is initially recorded in the functional currency using the exchange rate prevailing on the transaction date.

• Subsequent Measurement: After the initial recognition, foreign currency transactions are reviewed at each reporting date:

  • Monetary Items: Assets and liabilities that are settled in cash (like receivables and payables) are re-measured at the closing exchange rate. Any resulting exchange difference is recognized in the profit or loss.
  • Non-Monetary Items: Assets and liabilities that are not cash-based (like inventory and PPE) are generally not re-measured but are retained at their historical exchange rates.

2. Distinguish between Functional Currency and Presentational Currency

• Functional Currency:

  • Defined as the currency of the primary economic environment in which the entity operates.
  • It's influenced by factors such as sales market, the currency of costs, and the currency in which funds are raised or generated.
  • For example, for a U.S.-based company that primarily operates in the U.S., the functional currency would typically be the U.S. dollar (USD).

• Presentation Currency:

  • The currency in which the financial statements are presented.
  • An entity can choose any currency as its presentation currency, which may or may not be the same as its functional currency.
  • For instance, a U.S. company might prepare its financial statements in euros (EUR) for reporting purposes if it has significant operations in Europe.

3. Explain How Foreign Currency Transactions are Carried Out Directly by the Reporting Entity in Financial Statements

When a reporting entity conducts transactions in foreign currencies, the following steps are taken in the financial statements:

1. Initial Recognition: At the time of the transaction, convert the amount from the foreign currency to the functional currency using the spot exchange rate. For example, if a company sells a product for €10,000, and the exchange rate is 1.1 at the time of the transaction: \[ \text{Revenue in functional currency} = 10,000 \times 1.1 = $11,000 \]

2. Subsequent Measurement: At each reporting date, monetary items (such as receivables or payables in foreign currency) are re-measured at the closing exchange rate. For example, if the closing rate is 1.2: \[ \text{Value of receivable} = 10,000 \times 1.2 = $12,000 \]

   • Any difference due to changes in exchange rates is recognized in the profit or loss statement. If the initial value was $11,000 and is now $12,000, you would recognize a gain of $1,000.

3. Disclosures: Entities must disclose their foreign currency risks and the policies adopted to hedge those risks, if applicable.

4. Apply Foreign Currency Transactions to Overseas Transactions and Investments in Overseas Subsidiaries

Foreign currency transactions can also relate to investments in overseas subsidiaries. Here’s how to apply the principles:

1. Initial Investment: When a parent company invests in a foreign subsidiary, the investment is recorded at the spot exchange rate in the functional currency.

2. Subsequent Reporting:

   • If a foreign subsidiary conducts transactions and generates profits, these need to be consolidated into the parent company’s financial statements.
   • The financial statements of the foreign subsidiary are typically prepared in the subsidiary's functional currency and then converted to the parent’s presentation currency (if different).
   • The assets and liabilities of the subsidiary are translated at the closing exchange rate, while income and expenses are translated at the average exchange rate during the period.

3. Exchange Differences: Any exchange differences that arise during this translation process are recognized in other comprehensive income (OCI) under the cumulative translation adjustment in equity, rather than in profit or loss.

4. Disposal of Subsidiaries: When a foreign subsidiary is sold, any previously recognized exchange differences in OCI will be recognized in the profit or loss at the time of disposal.

By following these principles, businesses can systematically manage foreign currency transactions and effectively report their impact on financial statements, ensuring compliance with relevant accounting standards like IFRS or GAAP.